With the idea that it is reasonable for an insurer to prepare for a Realistic Disaster Scenario, but not practical to be prepared for all Worst Case scenarios. Not practical because the insurance would cost too much and less insurance would be sold.

With such a common language about frequency relating to stress tests, the results of the stress testing and the response to those results can make much more sense.

The outcomes of stress testing then fall into a pattern as well.

An insurer should be able to withstand normal volatility without any lasting reduction to capital.

An insurer should be able to withstand a Realistic Disaster for most of their risks without a game changing impairment of capital, i.e. it would be realistic for them to plan to earn their way back to their desired level of capital. For the most significant one or two risks, a Realistic Disaster may result in Capital impairment that requires special actions to repair. Special actions may include a major change to company strategy.

An insurer can usually withstand a Worst Case scenario for most of their risks with the likelihood that for some, there will be an impairment to capital that requires special actions to repair. For the largest one or two risks, the insurer is unlikely to be able to withstand the Worst Case scenario.

Those three statements are in fact a requirement for an insurer to be said to be effectively managing their risks.

So the ORSA and any other stress testing process should result in the development of the story of what sorts of stresses require special management actions and what types result in failure of the insurer. And for an insurer with a risk management program that is working well, those answers should be known for all but one or two of their risks. Those would the second and third largest risks. An insurer with a perfect risk management program will not have very much daylight between their first, second and third largest risks and therefore may well be able to survive some worst case scenarios for even their largest risks.

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RISKVIEWS believes that this may be the best top 10 list of posts in the history of this blog. Thanks to our readers whose clicks resulted in their selection.

Instructions for a 17 Step ORSA Process– Own Risk and Solvency Assessment is here for Canadian insurers, coming in 2015 for US and required in Europe for 2016. At least 10 other countries have also adopted ORSA and are moving towards full implementation. This post leads you to 17 other posts that give a detailed view of the various parts to a full ORSA process and report.

What kind of Stress Test? – Risk managers need to do a better job communicating what they are doing. Much communications about risk models and stress tests is fairly mechanical and technical. This post suggests some plain English terminology to describe the stress tests to non-technical audiences such as boards and top management.

ORSA ==> AC – ST > RCS– You will notice a recurring theme in 2014 – ORSA. That topic has taken up much of RISKVIEWS time in 2014 and will likely take up even more in 2015 and after as more and more companies undertake their first ORSA process and report. This post is a simple explanation of the question that ORSA is trying to answer that RISKVIEWS has used when explaining ORSA to a board of directors.

The History of Risk Management – Someone asked RISKVIEWS to do a speech on the history of ERM. This post and the associated new permanent page are the notes from writing that speech. Much more here than could fit into a 15 minute talk.

Hierarchy Principle of Risk Management– There are thousands of risks faced by an insurer that do not belong in their ERM program. That is because of the Hierarchy Principle. Many insurers who have followed someone’s urging that ALL risk need to be included in ERM belatedly find out that no one in top management wants to hear from them or to let them talk to the board. A good dose of the Hierarchy Principle will fix that, though it will take time. Bad first impressions are difficult to fix.

What CEO’s Think about Risk– A discussion of three different aspects of decision-making as practiced by top management of companies and the decision making processes that are taught to quants can make quants less effective when trying to explain their work and conclusions.

Decision Making Under Deep Uncertainty– Explores the concepts of Deep Uncertainty and Wicked Problems. Of interest if you have any risks that you find yourself unable to clearly understand or if you have any problems where all of the apparent solutions are strongly opposed by one group of stakeholders or another.

The Own Risk and Solvency Assessment (or Forward Looking Assessment of Own Risks based on ORSA principles) initially seems daunting. But the simple formula in the title of this post provides a guide to what is really going on.

The insurer needs to develop the capacity to project the financial and risk exposure statistics forward for several years under a range of specified conditions.

Included in the projection capacity is the ability to determine (a) the amount of capital required under their own risk capital standard and (b) the projected amount of capital available.

The insurer needs to select a range of Stress Tests that will be used for the projections.

If, under a projection based upon a Stress Test, the available capital exceeds the Risk Capital Standard, then that Stress Test is a pass. AC – ST >RCS

If, under a projection based upon a Stress Test, the available capital is less than the Risk Capital Standard, then that Stress Test is a fail and requires an explanation of intended management actions. AC – ST < RCS ==> MA

RISKVIEWS suggests that Stress Tests should be chosen so that the company can demonstrate that they can pass (AC – ST >RCS) the tests under a wide range of scenarios AND in addition, that one or several of the Stress Tests are severe enough to produce a fail (AC – ST < RCS ==> MA) condition so that they can demonstrate that management has conceptualized the actions that would be needed in extreme loss situations.

RISKVIEWS also guesses that an insurer that picks a low Risk Capital Standard and Normal Volatility Stress Tests will get push back from the regulators reviewing the ORSA.

RISKVIEWS also guesses that an insurer that picks a high Risk Capital Standard will fail some or all of the more severe Stress Tests.

Furthermore, RISKVIEWS predicts that many insurers will fail the real Future Worst Case Stress Tests. Only firms that hold themselves to a Robust Risk Capital Standard are likely to have sufficient capital to potentially maintain solvency. In RISKVIEWS opinion, these Future Worst Case Stress Tests are useful mainly as the starting point for a Reverse Stress Test process. In financial markets, we have experienced a real life worst case stress with the 2008 Financial Crisis and the following events. Imaging insurance worst case scenarios that are as adverse as those events seems useful to promoting insurer survival. Imagining events that are much worse than those – which is what is meant by the Future Worst Case Scenario idea – seems to be overkill. But, in fact, the history of adverse events in the recent past seems to indicate that each new major loss is at least twice the previous record.

A Reverse Stress Test is a process under which an insurer would determine the adverse scenario that drives the insurer to insolvency. Under the NAIC ORSA, Reverse Stress Tests are required, but it is not specified whether those tests should be based upon a condition of failing to meet the insurer’s own Risk Capital Standard or the regulators solvency standard. RISKVIEWS would recommend both types of tests be performed.

These seem to RISKVIEWS to fall into all six of the categories. Many of these scenarios would fall into the “Normal Volatility” category for some companies and into the worst historical for others. A few are in the area of “Future Worst Case” – such as the Treasury Collapse.

RISKVIEWS suggests that when doing Stress Testing, you should decide what sort of Stress you are intending. You may not agree with RISKVIEWS categories, but you should have your own categories. It might be a big help to the reader of your Stress Test report to know which sort of stress you think that you are testing. They may or may not agree with you on which category that your Stress Scenario falls into, and that would be a valuable revealing discussion.

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We can know, looking back at last year, how much risk that an insurer was exposed to. And we can simply look at the balance sheet to see how much capital that they held. So that is the way we have tended to look at solvency. Backwards. Was the insurer solvent last year end? Not really useful information. Unless…

That is, unless you make some potentially heroic assumptions about the future. Not an unusual assumption. Just that common assumption that the future will be just like the past.

That assumption is usually ok. Let’s see. In the past 15 years, it has been correct four or five times. But is that good enough for solvency work – a system that might give the right answer a third of the time?!?

But there is a solution. Regulators have led us right up to that solution but they haven’t yet dared to say what it is. Perhaps they do not know, or even that they are not thinking that the backward looking problem has two aspects. We are making two of the heroic assumptions:

We are assuming that the environment will be the same in the near future as the recent past.

We are assuming that the company activity will be the same in the near future as the recent past.

The regulatory response to these two shaky assumptions is:

Stress Scenarios

Look forward using company plans

Solution 1 can help, but solution 2 can be significantly improved by using the ERM program and risk appetite. You may have noticed that regulators have all said that ERM is very important. And that Risk Appetite is a very, very important part of ERM. But they have never, ever, explained why it is important.

Well, the true answer is that it can be important. It can be the solution to one part of the backward looking problem. The idea of looking forward with company plans is a step in the right direction. But only a half step. The full step solution is the FULL LIMIT STRESS TEST.

That test looks forward to see how the company will operate based upon the risk appetite and limits that management has set. ERM and risk appetite provide provide a specific vision of how much risk is allowed by management and the board. The plan represents a target, but the risk appetite represents the most risk that the company is willing to take.

So the FULL LIMIT STRESS TEST would involve looking at the company with the assumption that it chooses to take the full amount of risk that the ERM program allows. That can then be combined with the stress scenarios regarding the external environment.

Now the FULL LIMIT STRESS TEST will only actually use the risk appetite for firms that have a risk appetite and an ERM program that clearly functions to maintain the risk of he firm within the risk appetite. For firms that do not have such a system in place, the FULL LIMIT STRESS TEST needs to substitute some large amount of growth of risk that is what industry experience tells us that can happen to a firm that has gone partially or fully out of control with regard to its risk taking.

That makes the connection between ERM and Solvency very substantial and realistic.

A firm with a good risk management program and tight limits and overall risk appetite will need the amount of capital that would support the planned functioning of the ERM program. The overall risk appetite will place a limit on the degree to which ALL individual risk limits can be reached at the same time.

An otherwise similar firm with a risk management program and loose risk appetite will need to hold higher capital.

A similar firm with individual risk limits but no overall risk appetite will need to hold capital to support activity at the limit for every single risk.

A firm without a risk management program will need to hold capital to support the risks that history tells us that a firm with uncontrolled growth of risk might take on in a year. A track record of informal control of risk growth cannot be used as a predictor of the range of future performance. (It may be valuable to ask all firms to look at an uncontrolled growth scenario as well, but for firms with a good risk control process will be considered to prepare for that scenario with their ERM program.)

A firm without any real discipline of its risk management system will be treated similarly to a firm without an ERM program.

With this FULL LIMIT STRESS TEST, ERM programs will then be fully and directly connected to Solvency in an appropriate manner.

Distress lurks. Just out of sight. Perhaps around a corner, perhaps down the road just past your view.
For some their rule is “out of sight, out of mind”. For them, worry and preparation can start when, and if, distress comes into sight.

But risk managers see it as our jobs to look for and prepare for distress. Whether it is in sight or not. Especially because some sorts of distress come on so very quickly and some methods of mitigation take effect so slowly.
Stress testing is one of the most effective tools, both for imagining the potential magnitude of distresses, but almost more importantly, in developing compelling stories to communicate about that distress potential.

This week, Willis Wire is featuring a piece about Stress Testing in the “ERM Practices” series;